Economics

The euro crisis

Waiting for the fall-out

A WEEK late and billions of euros short euro-zone leaders have knocked out a deal with Cyprus over its ongoing banking crisis. Charlemagne provides key details here. The agreement is significantly better than last week's hash in a few ways. Insured depositors will not face losses; instead stockholders will be cleaned out, bondholders will be bailed in, and uninsured depositors will face big losses:

The country’s second-biggest bank, Laiki, would be wound down. Viable assets and insured deposits would be put into a “good bank”. Another €4.2 billion worth of uninsured deposits would be placed into a “bad bank”, to be disposed of, with no certainty that big depositors will get any money back.

The treatment of the biggest bank, Bank of Cyprus, was a bit less harsh. It is to be restructured severely by wiping out shareholders and bailing in bondholders, both junior and senior. Uninsured depositors would probably incur haircuts of the order of 35%, said senior sources involved in the negotiation. The “good bank” emerging from Laiki would be merged with Bank of Cyprus.

As Charlemagne notes, the deal isn't much different from that proposed by the IMF some time ago. The confusion and delay in reaching the new framework are bound to prove costly.

Several big questions remain. The most immediate concerns when Cypriot banks will reopen, what will happen to deposits at that time, and how the Cypriot government will respond. Major deposit flight is expected, and it is widely anticipated that temporary capital controls will be imposed. These may only include various withdrawal limits designed to prevent further deterioration in bank finances, but they could be broadened to include outright restrictions on the flow of money out of the country (see useful discussion here). In either case, but especially the latter, expect to hear a lot about how a euro in Cyprus is no longer the same as a euro in Germany. Some will argue that controls represent the end of monetary union (so far as Cyprus is concerned anyway) in all but name, and the crossing of the widest and deepest line in the sand. The key issue is whether that sort of outcome would say more about Cyprus or the euro zone. Markets continue to behave as though this mess is a uniquely Cypriot failure.

Question two concerns the broader economic fall-out for Cyprus. The failure of the second largest bank, major financial losses, capital flight, and the end of the country's biggest export industry all suggest that a collapse in GDP is in the cards, on the order of 10% to 20%: truly Depression-like, and similar to the fall in Greece. That, in turn, suggests that the financial troubles for the tiny country are far from over. Euro-area leaders remain interested in returning Cyprus' debt-to-GDP ratio to 100% by 2020 (post bail-out the ratio is expected to be close to 150%): tricky when GDP is expected to tumble. Cyprus may continue to incur bank bail-out costs while struggling to rebuild its economy; the salve of devaluation, about the only good thing that typically comes along with a crisis like this, is unavailable. Cyprus will probably require a new programme at some point, if not an outright debt restructuring.

And then there is the matter of how this might affect the crisis in the broader euro zone. Markets have staged a minor rally on the basis of the deal. Peripheral yields simply haven't reacted much to the Cyprus mess. There are no lines at Spanish ATMs. It is possible that the next time the crisis on the continent intensifies, the memory of the Cyprus ordeal will make depositors a little more likely to pre-emptively move their money. But short-term contagion doesn't look like a threat. Understandably; everyone knows that running anything like the Cyprus playbook in Spain or Italy would effectively mean the end of the euro area. Cyprus really was too small and peripheral to be confused for systemically important.

But it is hard to know how the flapping of butterfly wings in Cyprus might fan the broader storm. The past week reinforced a handful of damaging perceptions of euro-zone leaders: a general lack of competence, the core's insensitivity to peripheral economic pain, a disinterest in democratic accountability. On the margin, the Cyprus debacle may help fringe parties aiming to exploit frustration with the current political class. It may reduce cross-border trust in negotiations. It may further erode support for the euro project as a whole. And it may deter some spending and investment that might otherwise have helped nudge the euro zone back toward growth.

Placid markets, while welcome, can't distract us from the economic disaster about to hit Cyprus or the weeklong display of the euro zone's institutional weakness we have all just witnessed.

Europe's "disinterest in democratic accountability" keeps coming up in every article about Cyprus (or Greece or Spain and so on and so on). It seems to this casual observer 6,000 miles away that it's just the opposite: Germany (as a proxy for all the EU countries in the black) is behaving with utmost democratic accountability. Merkel wants to win elections, so she needs to be seen as being careful about spending her voters' money. Reasonable people can disagree about the efficacy of her decisions, but she is most certainly bound by "democratic accountability". If the Cypriots (as a unit, this is not about their internal decision-making) built up their banking sector to an level their economy couldn't support, and then don't want to pay the price others are demanding of them in exchange for a rescue, well, that's not exactly a lack of democracy. It seems more like a recalcitrant teenager who got busted for staying out past curfew.

IMO the most damning aspect of this whole experience has been the unprofessional way it was conducted - all night meetings, half-thought-out trial-balloons, desperate 11th-hour compromises and worst of all - a bunch of pols trying to pretend they're bankruptcy lawyers.

Two or three teams of experienced pros could have put this deal (which is pretty OK) together in a couple of weeks, and done so in a reasoned and legally trustworthy manner - and only had to go at it from 9 to 5, with a 90-minute lunch. But pols are too jealous of their authority, and have too much need to preen, to allow pros to play that kind of role.

Well, that's the eurozone crisis for you. A volatile mixture of finance, diplomacy and low politicking.

I'd say the markets are correct to be relaxed that this is a one-off:

1. Very unusual funding structure of the big cypriot banks. Almost no bond-holders to wipe out.
2. The low politics. The previous cypriot administration was communist. They really managed to piss off everybody and generally resist reality, and the new administration caught the fallout. (Their really big mistake, in my view? Threatening German Finance Minister Schäuble, during one of the meetings, with a default and exit, if the bailout didn't happen).

Cyprus may be a special case, but given the outrageous incompetence displayed throughout the Euro crisis, it may not stay so special.
.
What better way to solve a credit crisis than by punishing savers? It's so easy. It's so wrong. It's so stupid, especially for the long term.
.
How can the Eurofools resist?
.
As the famous American bank robber and philosopher Willie Sutton said, you rob banks "Because that's where the money is."

The process of deflation is summarized as, "I can't pay you, because she didn't pay me, because they didn't pay her. And therefore none of us has liquid capital with which to quench the fire or lubricate the overheating gears."
.
Cyprus, if not its citizens, still has no liquidity. And all the waters of the Mediterranean, although sufficient to isolate the island, are insufficient to stop the fire or restart its economy. It may slow the evacuation of the island, but it will not quench the fire or the thirst.
.
People will have air to breathe, water to drink, and perhaps bread to eat. But they will not have "Freedom to Choose", as the Nobel Laureate, Milton Friedman put it in the title of his book.
.
To update John Donne, "Ask not for whom the bill tolls. Whether you use euros or not, it tolls for thee."

"... the weeklong display of the euro zone's institutional weakness we have all just witnessed."
.
And what exactly was that "weakness" since the Troika had it its way - against Cyprus politicians, and perhaps Russia?

This is just the logical consequence of having a host banking system that's 8 times the size of your country's GDP. When the assets owned by your banking systems move by 4% and its size is 8 times your GDP, you're finished--as Iceland and now Cyprus have found out.

They bought some time, for which they mortgaged their future(s). Like David Copperfield's Mr. Micawber, they hope, "Something will turn up." Contrary to their hopes, "Interest rates, REAL interest rates, 'will turn up'."

The island of Cyprus has just been converted into a new kind of debtors' prison. Unlike "The King's Bench Prison" of Charles Dickens' day, this one is out[side] of time. Instead of the inflation they were hoping would liquidate their debts; deflation, silent but deadly, will raise their REAL interest rates.

This compounding will lead to a debt and death spiral.

The euro zone will keep quarantining more and more of its members to contain the contagion. And fewer and fewer creditor nations will have available liquid capital to lend at higher and higher REAL interest rates.

There will be some kind of crash. The euro zone will founder on the rocks and shoals of international competition and "World War Currency". And the markets will clear what's left in deflation.

After looking at today's Daily Chart, and considering Cyprus, and the other bailouts in comparison, it concerns me that the unprecedented levy on Cypriot savings above the deposit insurance maximum is more law enforcement aimed at Russian deposits of dubious provenance than it is a legitimate - though necessary - part of an economic restructuring.
.
I had not considered this before, but there is an unattractive odor here of indiscriminate collective punishment. How many innocent savers end up in the net?

It became clear that Europeans aren't concerned about "foreigners" losing money, as the press about Russians made clear. The worry was that European depositors would see themselves as being like the Russians and that worry was blunt because of the taking of ordinary Cypriot money below 100k Euros. We can't know if that fear would have become real because the deal was held up for renegotiation almost immediately. Now that the obvious grab of deposits is gone, Europeans can still think of this as being about Russians.

Measuring your height in centimeters rather than inches does not make you any taller.
.
Same way with currency; even if you stretch or shrink its comparative value, the economy stays the same; you can fool some investors in short term, but what's left after that?

one band aid after another...kicking the can down the road.. all these assume that bond vigilantes are slumbering. They are just frightened of the "printing press". When the politicians/bureaucrats run out of gas...the game starts.

Yes. Eurozone-wide Banking Regulation is definitely an idea whose time has come. This sort of insolvent bank mess happens quite a lot in a national context. The threats and the tears and the layoffs and the forced mergers happen just the same.

They just don't have to invite the politicians and the press to watch the ugly process. I've no experience in the field, but I did like this anecdote from the sudden forced merger of SachsenLB with LandesbankBW in 2008. (Cause: toxic subprime in the irish daughter company of SachsenLB)

SachsenLB Bank-Director (to regulator): "You're trying to push us up against a wall!"

Regulator (with, I like to imagine, an evil grin): "You think that's a wall behind you? That's not a wall, that's a chasm".

It mostly has to do with your trade relations. If you devalue, relative prices internally stay the same. But prices relative to the outside world change. So your exports get cheaper (you can sell more), and your expenses get more expensive (which causes people to buy fewer imports). In short, you have more money coming in from outside, and less going out.

The restoration of capital controls is unprecedented in EMU history, but so are many things in this crisis. Admittedly, it gives the Cypriot government many powers to keep the economy under the thumb, in stark contrast with the EU's largely liberal economic code. We should wonder if this odd status is worth an EU membership but there's barely another way to show Cyprus as a peculiar "basket" case and so the EU is likely to endorse this breach.
The belt-tightening imposed on citizens may be so burdensome that the hated 6.5% bank levy would seem a lesser evil, but there will be little or no time for regrets.
The EU risked losing a member to Russia, but now that Cyprus is grudgingly back into the fold it can use its predicament as a test case for both the banking and the fiscal union if this and any future aid is released with all strings attached.
This "special" treatment could even work fine, as long as there are no long queues of nervous depositors in front of banks in mainland EMU. The fact that Cyprus entered the euro-zone later on may keep it on the fringe, almost as if it never came on board. Unique case or not, the fall-out would be just delayed if present and future governments of the euro periphery think of themselves as sheltered forever.